Italy: What Happens When Austerity Takes a Holiday?

Candidate Pier Luigi Bersani won enough votes in the Italian election to control a part of parliament. Aged and oft-elected prime minister Silvio Berlusconi took defacto control of the senate. Between them neither has a love of austerity. Markets rejected that sentiment with sell-offs. The rejection may not be such a bad thing.

Austerity has proved itself to be a two-edged sword in Europe. On the one side, it means to cut deficits via lower expenses, and sometimes higher taxes. On the other side, the cuts slow economies and drop the sums that go into treasuries, which risks undermining the expense cuts and widening deficits.

If any proof is needed to show the negative effects of austerity, a look at Spain offers evidence. In recession, its unemployment rate is above 25% and growing. The intractable downturn is often blamed on a lack of stimulus and embrace of austerity, and so it goes.

The market's assumption about Italy is that its economy will become toxic if austerity is rejected. Bond buyers will dump its debt because an end to austerity will widen deficits and raise the national debt - a potential path to eventual default. But if the parties in Italy eventually form a coalition, which looks unlikely in the very short term, they might rally around stimulus measures. This would test whether stimulus has a chance to be the solution to some of Europe's economic problems. Of course, the Italians could spend money poorly to bolster their economy, and the effort will have been for nothing. But that can be said about any stimulus package in any nation in the world.

Italy may be the best chance for the best test of stimulus in a nation in Europe.

Filed under: 24/7 Wall St. Wire, International Markets Tagged: featured